Spain’s Bad Bank Needs Goodwill From Europe’s Leaders

Nov. 26 (Bloomberg) -- Spain is trying hard to shore up its
banking system, an endeavor crucial to the recovery of the euro
area’s fourth-largest economy. To improve the chances for
success, Europe’s leaders need to send a clear signal that the
costs to Spain’s government won’t get out of control.

On Dec. 1, Spain plans to put in place a central element of
its financial-sector rescue agreement with the European Union: a
“bad bank” designed to unburden the country’s commercial lenders
of some of their worst assets. The bank will spend as much as 90
billion euros ($115 billion) to buy foreclosed properties and
soured real-estate loans, at prices ranging from about 20
percent to 68 percent of face value. To mitigate the cost to the
government, it hopes to raise several billion dollars in capital
from private investors.

The move is more significant as an indicator of Spain’s
political will than as a salve for a troubled banking system. It
addresses only a small fraction of the 1.5 trillion euros in
assets that the government’s consultant, Oliver Wyman, has
identified as potentially problematic. At best, it will speed up
the process of recognizing losses at banks without much changing
the amount of capital they must raise to offset the losses.

Capital Needs

Even with the bad bank, Spain’s financial institutions will
need a lot of capital. Oliver Wyman’s adverse scenario projects
capital needs of about 60 billion euros, assuming losses of only
4.1 percent on some 600 billion euros in retail mortgage loans.
If a contracting economy and rising joblessness lead mortgage
borrowers to default in greater numbers, the amount of money
needed to keep Spain’s banking system afloat could be much
larger.

The big question, then, is how much of the cost will fall
on the already-strained budget of Spain’s government. In
principle, Spain can afford to spend 60 billion euros to prop up
its banks, or even the full 100 billion euros other governments
have offered to lend it for the purpose. The added borrowing
would increase the country’s debt burden by as much as nine
percentage points of gross domestic product, only marginally
affecting the longer-term challenge of getting its finances
under control. What’s more, Spain would use the money to
purchase bank equity, which it might eventually sell at a
profit.

The greater danger, for markets and for Spain’s solvency,
is that the government’s bailout costs might spiral out of
control as recession, banking paralysis and defaults reinforce
one another. As long as that risk remains, Spain will have a
hard time attracting investments and getting its economy growing
again.

Here’s where Europe’s leaders come in. They’ve pledged to
form a banking union in which governments would take collective
responsibility for overseeing banks and for recapitalizing (or
liquidating) them if they fail. They’ve stopped short, however,
of defining the point at which the new system would kick in.
Germany has suggested that “legacy” assets, such as Spanish
banks’ toxic real-estate loans, would be the sole responsibility
of national governments. This leaves the biggest issue for Spain
unresolved: What will happen if performing loans -- many of them
fueled by the past easy-lending practices of banks in Germany
and other euro-area countries -- turn sour in the future?

To restore confidence, the governments of the euro area
should set a reasonable limit -- say, 100 billion euros -- to
Spain’s responsibility for salvaging its banks. They should also
make sure the banking union is up and running in time to handle
any further capital needs. Slipping beyond the Jan. 1 target
date will only aggravate Europe’s financial and economic ills.

A currency union consisting of such varied economies as
Europe’s cannot survive unless its members share risks. The
predicament of Spain’s banking sector offers a test of European
leaders’ ability and willingness to do so. If it turns out that
they can’t or won’t, one wonders what they were thinking when
they created a joint currency in the first place.

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